Principles of Managerial Finance, 13e, Global Edition (Gitman) Chapter 12 Risk and Refinements in Capital Budgeting Budgeting
12.1 Understand the importance of recognizing risk in the analysis of capital budgeting projects. 1) In the real world, different projects hae different leels of risk. !s a result, the acceptance of a particular project generally has an impact on the firm"s oerall risk, although usually in a minor way #depending on size). !nswer$ %&U' %opic$ %o pic$ &ecognizing &isk in (apital udgeting *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 2) In the real world, different projects hae different leels of risk. !s a result, the acceptance of a particular project usually has an enormous impact on the firm"s oerall risk. !nswer$ -!+' %opic$ %o pic$ &ecognizing &isk in (apital udgeting *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills /) In a capital budgeting conte0t, con te0t, risk is the chance that a project will proe unacceptable or, more formally, the degree of ariability of cash flows. !nswer$ %&U' %opic$ %o pic$ &ecognizing &isk in (apital udgeting *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills ) !ll !ll projects should always use the !(( !(( as the re3uired re3uired return for capital budgeting purposes. !nswer$ -!+' %opic$ %o pic$ &ecognizing &isk in (apital udgeting *uestion +tatus$ 4ew !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 5) In a capital budgeting conte0t, con te0t, risk is generally thought of as the chance chan ce that 467 and I&& will proide conflicting recommendations to management. !nswer$ -!+' %opic$ %o pic$ &ecognizing &isk in (apital udgeting *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills
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:) In the conte0t of capital budgeting, risk generally refers to !) the degree of ariability of the cash inflows. ) the degree of ariability of the initial inestment. () the chance that the net present alue will be greater than zero. ;) the chance that the internal rate of return will e0ceed the cost of capital. !nswer$ ! %opic$ %o pic$ &ecognizing &isk in (apital udgeting *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills <) In a capital budgeting conte0t, con te0t, risk refers to !) the chance that a project will proe unacceptable. ) the degree of ariability of cash flows. () neither ! nor is correct. ;) both ! and are correct. !nswer$ ; %opic$ %o pic$ &ecognizing &isk in (apital udgeting *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 12.2 ;iscuss risk risk and cash cash inflows, scenario analysis, analysis, and simulation simulation as behaioral approaches for dealing with risk. 1) %he breakeen cash inflow is the minimum leel of cash inflow necessary for a project to be acceptable. !nswer$ %&U' %opic$ %o pic$ reakeen (ash Inflow *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 2) 6rojects with a small chance of being acceptable and a broad range of e0pected cash flows are more risky than projects haing a high chance of being acceptable and a narrow range of e0pected cash flows. !nswer$ %&U' %opic$ +ensitiity +ensiti ity !nalysis *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills /) In capital budgeting, risk refers to the chance chanc e that a project has a high degree of ariability of the initial inestment. !nswer$ -!+' %opic$ %o pic$ &ecognizing &isk in (apital udgeting *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills
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) +ensitiity analysis is a behaioral approach that uses a number of possible alues for a gien ariable to assess its impact on a firm"s return. !nswer$ %&U' %opic$ +ensitiity +ensiti ity !nalysis *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 5) +ensitiity analysis is a statistically based approach used in capital budg eting to get a feel for risk by applying predetermined probability distributions and random numbers to estimate risky outcomes. !nswer$ -!+' %opic$ +ensitiity +ensiti ity !nalysis *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills :) +cenario analysis is an approach that uses a number of possible alues for a gien ariable in order to assess its impact on a firm"s return. !nswer$ -!+' %opic$ %o pic$ +cenario !nalysis *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills <) +imulation is an approach that ealuates e aluates the impact on return of simultaneous changes in a number of ariables. !nswer$ -!+' %opic$ +imulation +imulatio n !nalysis *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills =) %he output of simulation proides an e0cellent basis for decision making since it allows the decision maker to iew a continuum con tinuum of risk>return trade>offs rather than a single>point estimate. !nswer$ %&U' %opic$ +imulation +imulatio n !nalysis *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills ?) ehaioral approaches for dealing with risk include scenario analysis and simulation. !nswer$ %&U' %opic$ %o pic$ &ecognizing &isk in (apital udgeting *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 19) ehaioral approaches for dealing with risk include adjusted net present alue and risk> adjusted discount rates. !nswer$ -!+' %opic$ %o pic$ &ecognizing &isk in (apital udgeting *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills / (opyright 8 2912 6earson 'ducation
11) +cenario analysis is a statistics>based behaioral approach that applies predetermined probability distributions and random numbers to estimate estimate risky outcomes. !nswer$ -!+' %opic$ %o pic$ +cenario !nalysis *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 12) +imulation is a statistics>based behaioral approach that applies predetermined probability distributions and random numbers to estimate risky outcomes. !nswer$ %&U' %opic$ +imulation +imulatio n !nalysis *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 1/) +cenario analysis is a behaioral approach that ealuates the impact on the firm"s return of simultaneous changes in a number of ariables. !nswer$ %&U' %opic$ %o pic$ +cenario !nalysis *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 1) +imulation analysis is a behaioral approach that ealuates the impact on the firm"s return of simultaneous changes in a number of ariables. !nswer$ -!+' %opic$ +imulation +imulatio n !nalysis *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 15) %he adantage of using simulation in the capital budgeting process is !) ease of calculation. ) the aailability of a continuum of risk>return trade>offs which may be used as the basis for decision>making. () dependability of predetermined probability distributions. ;) that it generates a continuum of risk>return trade>offs rather than a single>point estimate. !nswer$ %opic$ +imulation +imulatio n !nalysis *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills
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Table 12.1
! corporation is assessing the risk of two capital budgeting proposals. %he financial analysts hae deeloped pessimistic, most likely, likely, and optimistic estimates of the annual cash inflows which are gien in the following table. %he firm"s cost of capital is 19 percent.
1:) %he range of o f the annual cash inflows for 6roject ! is @@@@@@@@. #+ee %able 12.1) !) A/9,999 ) A19,999 () A5,999 ;) A9 !nswer$ %opic$ +ensitiity +ensiti ity !nalysis *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ !nalytic skills 1<) If the projects hae fie>year lies, the range of the net present alue for 6roject is appro0imately @@@@@@@@. #+ee %able %able 12.1) !) A=9,5:9 ) A291,999 () A255,19 ;) A/9/,2=9 !nswer$ ; %opic$ +ensitiity +ensiti ity !nalysis *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ !nalytic skills 1=) %he e0pected net present alue of project ! if the outcomes are e3ually probable and the project has fie>year life is @@@@@@@@. #+ee %able %able 12.1) !) >A1,95 ) A1<,?19 () A/:,=:5 ;) A?/,
1?) ehaioral approaches for dealing with project risk !) e0plicitly recognize project risk. ) are used to get a feel for project risk. () are used both to get a feel for project risk and also e0plicitly recognize project risk. ;) none of the aboe. !nswer$ %opic$ %o pic$ ehaioral !pproaches *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 29) reakeen cash inflow refers to !) the minimum leel of cash inflow necessary for a project to be acceptable, that is, 467 B A9. ) the minimum leel of cash inflow necessary for a project to be acceptable, that is, 467 C A9. () the minimum leel of cash inflow necessary for a project to be acceptable, that is, I&& C cost of capital. ;) none of the aboe is correct. !nswer$ ! %opic$ %o pic$ reakeen (ash Inflow *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 21) %angshan %angshan Dining (ompany, with a cost co st of capital of 19 percent, is considering inesting in project !, !, with an initial inestment of A1,999,999. 6roject ! is e0pected to proide e3ual cash inflows oer its 15 year useful life. ased on this information, the breakeen cash inflow for the project is !) A1,999,999. ) A1/1,<. () A199,999. ;) none of the aboe. !nswer$ %opic$ %o pic$ reakeen (ash Inflow *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ !nalytic skills 22) ! behaioral approach that ealuates the impact on the firm"s return of simultaneous changes in a number of project ariables is called !) sensitiity analysis. ) scenario analysis. () simulation analysis. ;) none of the aboe. !nswer$ %opic$ %o pic$ +cenario !nalysis *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills
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2/) Ene type of simulation program made popular by the widespread use of personal p ersonal computers is called !) Donaco +imulation. ) emans +imulation. () (annes +imulation. ;) Donte (arlo +imulation. !nswer$ ; %opic$ +imulation +imulatio n !nalysis *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 12./ &eiew the uni3ue risks risks that multinational companies face. face. 1) In international trade, transfer prices are prices that subsidiaries charge each other for the goods and serices traded between them. !nswer$ %&U' %opic$ %o pic$ International &isk !nalysis *uestion +tatus$ &eised !!(+ uidelines$ ;ynamics of the global economy 2) -oreign direct inestment is the transfer of capital, managerial, and technical assets to a foreign country. !nswer$ %&U' %opic$ %o pic$ International (apital udgeting *uestion +tatus$ &eised !!(+ uidelines$ ;ynamics of the global economy /) %he danger that an une0pected change in the e0change rate between the dollar and the currency in which a project"s cash flows are denominated can increase the market alue of that project"s cash flow. !nswer$ -!+' %opic$ %o pic$ International &isk !nalysis *uestion +tatus$ &eised !!(+ uidelines$ ;ynamics of the global economy ) International capital budgeting differs from domestic capital budgeting because #1) cash inflows and outflows occur in a foreign currency, and #2) foreign inestments potentially face significant political risk. !nswer$ %&U' %opic$ %o pic$ International (apital udgeting *uestion +tatus$ &eised !!(+ uidelines$ ;ynamics of the global economy
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5) In case of international capital budgeting, a U.+. company can minimize its political risk by creating a joint enture with a competent co mpetent and well>connected local partner. !nswer$ %&U' %opic$ %o pic$ International (apital udgeting *uestion +tatus$ &eised !!(+ uidelines$ ;ynamics of the global economy :) In case of international capital budgeting, long>term currency risk can be minimized by at least partly financing the foreign inestment with a dollar>denominated capital contribution from the parent company rather than in the local capital markets. !nswer$ -!+' %opic$ %o pic$ International (apital udgeting *uestion +tatus$ &eised !!(+ uidelines$ ;ynamics of the global economy <) %he importance and widespread use of transfer pricing in international trade makes capital budgeting in D4(s ery difficult unless the the transfer prices used accurately reflect actual costs and incremental cash flows. !nswer$ %&U' %opic$ %o pic$ International &isk !nalysis *uestion +tatus$ &eised !!(+ uidelines$ ;ynamics of the global economy =) %he three basic types of risk associated with international cash flows are 1) business and financial risks, 2) inflation and foreign e0change risks, and /) political risks. !nswer$ %&U' %opic$ %o pic$ International &isk !nalysis *uestion +tatus$ &eised !!(+ uidelines$ ;ynamics of the global economy ?) '0change rate risk is the the risk that an une0pected change in e0change rates will reduce the market alue of a project"s cash flows. !nswer$ %&U' %opic$ %o pic$ International &isk *uestion +tatus$ &eised !!(+ uidelines$ ;ynamics of the global economy 19) In general, e0change rate risk is easier to protect against than political risk. !nswer$ %&U' %opic$ %o pic$ International &isk *uestion +tatus$ &eised !!(+ uidelines$ ;ynamics of the global economy 11) In general, political risk is easier to protect against than e0change rate risk. !nswer$ -!+' %opic$ %o pic$ International &isk *uestion +tatus$ &eised !!(+ uidelines$ ;ynamics of the global economy = (opyright 8 2912 6earson 'ducation
12) In international capital budgeting decisions, political risks can be minimized using all of the following strategies 'F('6% !) structuring the inestment as a joint enture and selecting well>connected local partner. ) structuring the financing of such inestments as e3uity rather than as debt. () structuring the financing of such inestments as debt rather than as e3uity. ;) none of the aboe. !nswer$ %opic$ %o pic$ International (apital udgeting *uestion +tatus$ &eised !!(+ uidelines$ ;ynamics of the global economy 1/) Important types of risk in an international capital budgeting bu dgeting conte0t include all of the following 'F('6% !) e0change rate risk. ) political risk. () appropriation risk. ;) all of the aboe are correct. !nswer$ ( %opic$ %o pic$ International &isk (onsiderations (onsiderations *uestion +tatus$ &eised !!(+ uidelines$ ;ynamics of the global economy 12. ;escribe the determination and use of risk>adjusted discount discount rates #&!;&s), portfolio portfolio effects, and the practical aspects of &!;&s. 1) %he risk>adjusted discount rate #&!;&) is the risk>adjustment factor that represents the percent of estimated cash inflows that inestors would would be satisfied to receie for certain rather than the cash inflows that are possible for each year. !nswer$ -!+' %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 2) %he risk>adjusted discount rate #&!;&) is the rate of return that must be earned on a gien project to compensate the firm"s owners ade3uately, ade3uately, thereby resulting in the maintenance or improement of share price. !nswer$ %&U' %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills /) ! market risk>return function is a graphical presentation of the discount rates associated with each leel of project risk. !nswer$ %&U' %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills ? (opyright 8 2912 6earson 'ducation
) &isk>adjusted discount rates #&!;&s) are the risk>adjustment factors that represent the percent of estimated cash inflows that inestors would would be satisfied to receie for certain rather than the cash inflows that are possible for each year. !nswer$ -!+' %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 5) ecause of the basic mathematics of compounding compound ing and discounting, the risk>adjusted discount rate #&!;&) approach implicitly assumes that risk is an increasing function of time. !nswer$ %&U' %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills :) %he higher the risk of a project, the higher its risk>adjusted discount rate and thus the lower the net present alue for a gien stream of cash inflows. !nswer$ %&U' %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills <) %he risk>adjusted discount rate is the rate of return that a project must earn to maintain or improe the firm"s share price. !nswer$ %&U' %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills =) %he risk>adjusted net present alue is the rate of return that a project must earn to maintain or improe the firm"s share price. !nswer$ -!+' %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills ?) %he risk>adjusted discount rate can be computed as the risk free rate plus the product of a project"s beta and the market risk premium. !nswer$ %&U' %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills
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19) %he risk>adjusted discount rate can be computed as the risk free rate plus the product of a project"s beta and the market return. !nswer$ -!+' %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 11) In applying risk>adjusted discount rates to project selection, projects falling aboe the +D would hae a positie 467 and those falling below the +D would hae a negatie 467. 467. !nswer$ %&U' %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 12) In applying risk>adjusted discount rates to project selection, projects falling aboe the +D would hae a negatie 467 and those falling below the +D would hae a positie 467. 467. !nswer$ -!+' %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 1/) ecause a business firm can be iewed as a portfolio of assets, it is important that the firm maintain a diersified portfolio of assets. !nswer$ -!+' %opic$ 6ortfolio 'ffects *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 1) 'en though a business firms can be iewed as a portfolio of assets, firms are not rewarded for selecting a diersified portfolio of assets because inestors can more efficiently diersify away unsystematic risk on their own. !nswer$ %&U' %opic$ 6ortfolio 'ffects *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 15) ;espite their focus on total risk, &!;&s are often used in practice. !nswer$ %&U' %opic$ %o pic$ &!;&s in in 6ractice *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills
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1:) ecause of their focus on total risk, &!;&s are the best theoretical method for adjusting for project risk and are therefore used most often in practice. !nswer$ -!+' %opic$ %o pic$ &!;&s in in 6ractice *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 1<) %he amount by which the re3uired discount rate e0ceeds the risk>free rate is called !) the opportunity cost. ) the risk premium. () the risk e3uialent. ;) the e0cess risk. !nswer$ %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 1=) %he @@@@@@@@ reflects the return that must be earned on the gien project to compensate the firm"s owners ade3uately according to the project"s ariability of cash flows. !) internal rate of return ) cost of capital () risk>adjusted discount rate ;) aerage rate of return !nswer$ ( %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 1?) %he preferred approach for risk adjustment of capital budgeting cash flows, from a practical iewpoint, is !) sensitiity analysis. ) simulation. () certainty e3uialents. ;) risk>adjusted discount rates. !nswer$ ; %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 29) %he theoretical basis from which the concept of risk>adjusted discount rates is deried is !) the ordon model. ) the capital asset pricing model. () simulation theory. ;) the basic cost of money. !nswer$ %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 12 (opyright 8 2912 6earson 'ducation
Table 12.2
! firm is considering inestment in a capital project which is described below. %he firm"s cost of capital is 1= percent and the risk>free rate is : percent. %he project has a risk inde0 of 1.5. %he firm uses the following e3uation to determine the risk adjusted discount rate, &!;&, for each project$ &!;& G &f H &isk Inde0 #(ost of capital > &f)
21) %he net present alue without adjusting the discount rate for risk is @@@@@@@@. #+ee %able 12.2) !) A//:,999 ) A259,999 () A1!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ !nalytic skills 22) %he discount rate that should be used in the net present alue calculation to compensate for risk is @@@@@@@@. #+ee %able %able 12.2) !) : percent ) 15 percent () 1= percent ;) 2 percent !nswer$ ; %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ !nalytic skills 2/) %he net present alue of the project when adjusting for risk is @@@@@@@@. #+ee %able 12.2) !) >A?,599 ) A9 () A=<,999 ;) A195,999 !nswer$ ! %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ !nalytic skills
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2) It has been found that the alue of the stock of corporations whose shares are traded publicly in an efficient marketplace is !) generally positiely affected by diersification, because of the reduction in risk. ) generally negatiely affected by diersification, because of the increase in risk. () generally not affected by diersification, unless greater returns are e0pected. ;) generally negatiely affected by diersification, because of the increase in the re3uired rate of return. !nswer$ ( %opic$ 6ortfolio 'ffects *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills Table 12.3
%angshan %angshan Dining (ompany is considering inestment in one on e of two mutually e0clusie projects D and 4 which are described below. %angshan %angshan Dining"s oerall cost of capital is 15 percent, the market return is 15 percent and the risk>free rate is 5 percent. %angshan estimates that the beta for project D is 1.29 and the beta for project 4 is 1.9.
25) Using the risk>adjusted discount rate method of project ealuation, the 467 for project D is @@@@@@@@. #+ee %able %able 12./) !) A15:,?. ) A122,?<9. () A=5,!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ !nalytic skills 2:) Using the risk>adjusted discount rate method of project ealuation, the 467 for project 4 is @@@@@@@@. #+ee %able %able 12./) !) A1::,1/2. ) A122,?<9. () A=5,!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ !nalytic skills 1 (opyright 8 2912 6earson 'ducation
2<) Using the risk>adjusted discount rate method of project ealuation, the better inestment for %angshan %angshan Dining is @@@@@@@@. @@ @@@@@@. #+ee %able 12./) !) 6roject D. ) 6roject 4. () they are e3uialent. ;) none of the aboe. !nswer$ ! %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ !nalytic skills 2=) hich project, D or 4, would be preferable if both projects were of aerage risk as the oerall firm and %angshan Dining has a beta of 1.9 #+ee %able %able 12./) !) 6roject D. ) 6roject 4. () %hey are e3uialent. ;) none of the aboe. !nswer$ %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ !nalytic skills 2?) hich of the following statements is most correct !) ecause a business firm can be iewed as a portfolio of assets, it is important that the firm maintain a diersified portfolio of inestments in order to reduce firm diersifiable risk. ) -irm"s are rewarded for choosing and implementing from among a diersifiable collection of projects through higher stock alues. () -irms generally are not rewarded for choosing and implementing from among a diersifiable collection of projects through higher stock prices. ;) %wo %wo of the aboe are true. !nswer$ ( %opic$ 6ortfolio 'ffects *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills
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Table 12.4
Johnson -arm Implement is faced with two mutually e0clusie projects, p rojects, 6 and *. %he following are the data about the two projects.
/9) 'aluate the projects using risk>adjusted discount rates. #+ee %able %able 12.) !nswer$ 4676 G #15,999K.1)0L1>1K#1.1)/M > 9,999 G >A2,:?5 467* G #25,999K.1)0L1>1K#1.1)/M > 59,999 G A=,959 %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ !nalytic skills /1) hich project do you recommend #+ee %able %able 12.) !nswer$ 6roject 6 has a negatie net present alue using &!;&s. 6roject * has a positie 467 of A=,959 using &!;&s. 6roject * is recommended. %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills Table 12.5
4ico Danufacturing is considering inestment in one of two mutually e0clusie projects F and N which are described below. 4ico Danufacturing"s oerall cost of capital is 15 percent, the market return is 15 percent and the risk>free rate is 5 percent. 4ico estimates that the beta for project F is 1.29 and the beta for project N is 1.9.
/2) (alculate the risk>adjusted discount rates for project F and project N. #+ee %able 12.5) !nswer$ r 0 G 5O H 1.29 #15O > 5O) G 1 5O) G 1?O %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ !nalytic skills 1: (opyright 8 2912 6earson 'ducation
//) Using the risk>adjusted discount rate method of project ealuation, find the 467 for projects F and N. hich project should 4ico select using this method #+ee %able 12.5) !nswer$
%opic$ &isk>!djusted ;iscount &ate %opic$ *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ !nalytic skills /) (alculate the 467 of projects F and N assuming that the firm did not employ the &!;& method and instead used the firm"s oerall cost of capital to ealuate projects F and N. N. #+ee %able %able 12.5) !nswer$
%opic$ &isk>!djusted ;iscount &ate %opic$ *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ !nalytic skills 1< (opyright 8 2912 6earson 'ducation
/5) hat potential biases e0ist in project selection if 4ico Danufacturing did not adjust for the difference in risk between projects F and N #+ee %able %able 12.5). !nswer$ %he danger of not accounting for differences in project risk is that that the firm may potentially unacceptable high>risk projects #with negatie 467s) may may be chosen oer potentially acceptable low>risk projects #with positie 467s). %opic$ %o pic$ &isk>!djusted ;iscount &ate *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 12.5 +elect the best of a group of une3ual>lied, mutually e0clusie projects using annualized net present alues #!467s). 1) In case of une3ual>lied, mutually e0clusie projects, the use of net present alue to select the better project could result in an incorrect decision. !nswer$ %&U' %opic$ !nnualized 4et 6resent 7alues 7alues *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 2) hen une3ual>lied projects are independent, the length of the projects" lies is not critical. !nswer$ %&U' %opic$ !nnualized 4et 6resent 7alues 7alues *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills /) hen une3ual>lied projects are independent, the impact of differing lies must be considered because the projects do not proide serice oer comparable time periods. !nswer$ -!+' %opic$ !nnualized 4et 6resent 7alues 7alues *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills ) In selecting the best group of une3ual>lied projects, if the projects are independent, the length of the projects lies is not critical. !nswer$ %&U' %opic$ %o pic$ 6rojects with with Une3ual ies ies *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 5) In selecting the best group of une3ual>lied projects, if the projects are mutually e0clusie, the length of the projects lies is not critical. !nswer$ -!+' %opic$ %o pic$ 6rojects with with Une3ual ies ies *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills
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:) %he annualized net present alue approach to ealuating projects with une3ual lies conerts the net present alue of une3ual>lied, mutually e0clusie projects into an e3uialent annual amount. !nswer$ %&U' %opic$ !nnualized 4et 6resent 7alues 7alues *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills <) %he risk>adjusted discount rate approach to ealuating projects with un e3ual lies conerts the net present alue of une3ual>lied, mutually e0clusie projects into an e3uialent annual amount. !nswer$ -!+' %opic$ !nnualized 4et 6resent 7alues 7alues *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills =) %he @@@@@@@@ approach is used to conert the net present alue of une3ual>lied projects into an e3uialent annual amount #in net present alue terms). !) internal rate of return ) inestment opportunities schedule () risk>adjusted discount rate ;) annualized net present alue !nswer$ ; %opic$ !nnualized 4et 6resent 7alues 7alues *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills
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Table 12.
Nong Nong Importers, an !sian import company, is ealuating two mutually e0clusie projects, ! and . %he releant cash flows for each project are gien in the table below. %he cost of capital for use in ealuating each of these e3ually risky projects is 19 percent.
?) %he 467s of projects p rojects ! and are @@@@@@@@. #+ee %able 12.:) !) A?5,9:: and A5:,/=:, respectiely ) A5:,/=: and A?5,9::, respectiely () >A5:,/=: and >A?5,9::, respectiely ;) none of the aboe !nswer$ %opic$ !nnualized 467 *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ !nalytic skills 19) %he !nnualized 467 of project ! is @@@@@@@@. #+ee %able 12.:) !) A22,:
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12) hich project should be chosen on the basis of the normal 467 approach #+ee %able %able 12.:) !) 6roject ! ) 6roject () neither ;) both !nswer$ %opic$ !nnualized 467 *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 1/) hich project should be chosen using the !nnualized 467 approach #+ee %able 12.:) !) 6roject ! ) 6roject () neither ;) both !nswer$ ! %opic$ !nnualized 467 *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 1) ! firm is ealuating two mutually e0clusie projects that hae une3ual lies. %he firm must ealuate the projects using the annualized net present alue approach and recommend which project they should select. %he firm"s cost of capital capital has been determined to be 1 percent, and the projects hae the following initial inestments and cash flows$
!) (hose 6roject & because its !467 is A::9 ) (hose 6roject + because its !467 is A::9 () (hose 6roject & because its !467 is A1=,2< ;) (hose 6roject + because its !467 is A19:/< !nswer$ %opic$ !nnualized 467 *uestion +tatus$ 4ew !!(+ uidelines$ uidelines$ !nalytic skills
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15) ! firm is ealuating two mutually e0clusie projects that hae une3ual lies. %he firm must ealuate the projects using the annualized net present alue approach and recommend which project they should select. %he firm"s cost of capital capital has been determined to be 1= percent, and the projects hae the following initial inestments and cash flows$
!nswer$
!467 of 6roject $ A22,59K/.12< G A<,29= !467 of 6roject N$ A1:,?99K2.1< G A<,<< +elect 6roject N, highest !467. %opic$ !nnualized 467 *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ !nalytic skills 12.: '0plain the role of real options and the objectie objectie and procedures for selecting selecting projects under capital rationing. 1) ! firm with limited funds for inestment in capital assets must ration those funds by allocating them to projects that will ma0imize share alue. !nswer$ %&U' %opic$ %o pic$ (apital &ationing *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 2) &eal options are opportunities that are embedded in capital budgeting projects that enable managers to alter their cash flows and risks in a way that affects project acceptability. !nswer$ %&U' %opic$ %o pic$ &eal Eptions *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills
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/) !djusted !djusted net present alues are opportunities o pportunities that are embedded in capital budgeting bud geting projects that enable managers to alter their cash flows and risks in a way that affects project acceptability. !nswer$ -!+' %opic$ %o pic$ &eal Eptions *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills ) %he objectie of capital rationing is to select the g roup of projects that proides the highest oerall net present alue and does not re3uire more dollars than are budgeted. budg eted. !nswer$ %&U' %opic$ %o pic$ (apital &ationing *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 5) %he objectie of capital rationing is to select the g roup of projects that proides the 3uickest oerall payback and does not re3uire more dollars than are budgeted. !nswer$ -!+' %opic$ %o pic$ (apital &ationing *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills :) ! firm with unlimited funds must ealuate fie projects. 6rojects 1 and 2 are independent and 6rojects /, , and 5 are mutually e0clusie. %he projects are listed with their returns.
! ranking of the projects on the basis of their returns from the best to the wo rst according to their acceptability to the firm would be !) , 1, 2 or 5, and /. ) , 1, and 2. () /, 2 or 5, 1, and . ;) , 1, 5, and /. !nswer$ %opic$ %o pic$ Independent ersus Dutually Dutually '0clusie 6rojects *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ !nalytic skills
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<) !s a top manager, you must decide firm which of the proposed projects should be accepted for the upcoming year since only A: million million is aailable for the ne0t year"s capital budget. hat is the total 467 of the projects that should be accepted
!) !, , P -Q total cost G A5.5 millionQ %otal %otal 467G A1.5< ) -, , P ;Q total cost G A: millionQ %otal %otal 467G A1.<2 () ', -, P ;Q total cost G A:5.5 milliomQ %otal %otal 467G A1.5 ;) (an not be determined. !nswer$ %opic$ %o pic$ Independent ersus Dutually Dutually '0clusie 6rojects *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ !nalytic skills =) %he ordering of capital e0penditure projects on the basis of some predetermined measure such as the rate of return is called !) the ranking approach. ) an independent inestment. () the accept>reject approach. ;) a mutually e0clusie inestment. !nswer$ ! %opic$ %o pic$ !ccept>&eject ersus ersus &anking !pproaches !pproaches *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills ?) %he objectie of @@@@@@@@ is to select the group of projects that proides the highest oerall net present alue and does not re3uire more dollars than are budgeted. !) capital rationing ) scenario analysis () certainty e3uialents ;) sensitiity analysis !nswer$ ! %opic$ %o pic$ (apital &ationing *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills
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19) %he I&& approach to capital rationing inoles graphically plotting project I&&s in descending order against total dollar inestment on @@@@@@@@ graph. !) an !467 ) an 467 () an &!;& ;) an IE+ !nswer$ ; %opic$ %o pic$ (apital &ationing *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 11) If a firm has a limited capital budget and too many good capital projects to fund them the m all, it is said to be facing the problem of !) constrained capital. ) wealth optimization. () capital rationing. ;) profitability. !nswer$ ( %opic$ %o pic$ (apital &ationing *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 12) Dajor types of real options include all of the following 'F('6% the !) abandonment option. ) timing option. () conersion option. ;) growth option. !nswer$ ( %opic$ %o pic$ &eal Eptions *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills 1/) !n approach to capital rationing that inoles graphing project returns in descending order against the total dollar inestment to determine the group of acceptable projects is called the !) net present alue approach. ) the internal rate of return approach. () the payback approach. ;) the profitability inde0 approach. !nswer$ %opic$ %o pic$ (apital &ationing *uestion +tatus$ &eised !!(+ uidelines$ uidelines$ &eflectie thinking thinking skills skills
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